It
may have been the mood evoked by Davos. Or it may be
the ''confidence'' that comes at the fag end of a successful
tenure. But State Bank of India Chairman Om Prakash
Bhatt took many by surprise when he defended the ''teaser''
loan scheme for housing that the Reserve Bank of India
has been advising banks to withdraw (See Indian Express,
31 January 2011).
Teaser loans, which gained in notoriety in the run up
to sub-prime crisis in the United States, offer loans
for housing that involve relatively low interest rates
during the early phases of the loan. These rates are
then reset and instalments on the loan hiked substantially
to cover the full charges due on the loan during its
tenure at the appropriate interest and amortisation
rate.
It should be obvious that teaser rates are offered to
attract borrowers, some of whom may have stayed out
of the market if higher rates were applicable immediately.
The difficulty is that some of these borrowers may be
making erroneous projections of future incomes or not
even calculating the burden they would have to carry
when rates are reset. In addition, if the rates charged
when they are reset are floating rates, borrowers may
not have factored in the danger of an increase in the
interest costs that may ensue. In the event, borrowers
who may not be in a position to carry the repayment
burden may be drawn into the universe of borrowers.
Bhatt’s defence of the scheme in India is four-fold.
First, that when checking the eligibility of a borrower,
what is examined is his or her ability to repay the
loan at the higher interest rate that kicks in during
the later phases of the loan. Second, that (for reasons
that are not clear) for ''anyone who takes a home loan,
repayment is generally difficult in the first two-three
years.'' Third that since teaser rates are being charged
on loans of smaller sizes (less than Rs. 10 lakh), they
benefit the aam admi. And, finally, that NPAs on home
loans are the lowest and the bank has the benefit of
the client’s house as collateral to ensure the safety
of the credit asset.
The first two of these arguments are without substance.
If clients are those who are seen as being able to cover
the higher rate, the reason why they are being offered
a teaser in the first instance is not clear. And if
they are worthy borrowers of this kind, the argument
that they would find it difficult to pay their instalments
in the first year or two and then feel comfortable to
do so is also a bit difficult to swallow. The point
is that Mr. Bhatt should know otherwise. The debate
on teaser loans is no invention of the Reserve Bank
of India. It has arisen out of what experience has taught
us in other contexts, including during the recent sub-prime
crisis.
From the point of view of banks opting for teaser rate
loans, such rates are essentially a means of expanding
their retail lending business. If that is the motivation,
driven by say access to additional cheap liquidity,
banks may be less diligent when assessing the eligibility
of borrowers. This has consequences both positive and
negative. Lending practices that seek to attract borrowers
kept out of credit markets in the past are indeed democratic,
inasmuch as they deliver credit to those who could not
access credit before. When this occurs in the housing
market, it does, through market mediated mechanisms,
expand the population that is able to own their own
homes. However, one fall-out of this tendency could
be an increase in lending to less creditworthy or sub-prime
borrowers and therefore in the proportion of defaults
and foreclosures. When defaults are not too high foreclosures
permit recovering the capital lent out by the banks.
But if defaults and foreclosures proliferate, housing
markets are bound to be depressed making it difficult
for banks to recover their capital. Hence, when loan
pushing is stretched beyond a point and continues for
long, default percentages can rise to levels where they
could affect the viability of individual banks and the
banking system. This is what partly happened during
the sub-prime crisis.
It is in this background that we need to assess the
apprehensions expressed by India’s banking regulator,
the Reserve Bank of India, regarding lending for housing
purchases in general and lending based on teaser loans
in particular. It has been known for some time now that,
facilitated and encouraged by financial liberalisation,
Indian banks have been following international trends
and expanding their retail lending substantially, so
much so that well above a fifth of commercial bank advances
are now to the retail sector. A very high proportion
of those advances have been to housing, which finances
an asset that serves as the best collateral. Hence,
early into this trend the RBI had cautioned banks against
excessive exposure to the housing market. Yet banks
not only expanded such lending but opted to push credit
for housing using schemes such as teaser rate loans.
In response, the regulator has through a series of measures
sought to rein in such ending. In its Annual Policy
Statement for 2006-07 the Reserve Bank of India increased
the general provisioning requirement for residential
housing loans exceeding Rs 20 lakh from 0.40 per cent
to 1.0 per cent. Subsequently, the RBI warned banks
against resorting to teaser interest rates, given the
experience with the consequences of such rates in the
US and other contexts. However, the risk weight on bank
exposure to housing loans continued to be kept low and
a substantial segment of home loans falling below Rs.
20 lakhs were kept within the ambit of the ''priority
sector'', which consists of a combination of sectors
like agriculture and small-scale industry to which a
specified minimum percentage of total lending is required
to be directed by the banks (40 per cent for the scheduled
commercial banks). This treatment of housing as a priority
sector is partly because the government has not been
able to provide adequate volumes of affordable housing.
However, in the process India may be encouraging a trend
that increases the fragility of the housing finance
market and therefore of the financial and the real economy.
That the RBI fears such a trend emerges from its monetary
policy review for the second quarter of 2010-11, in
which it sent out a strong signal that it wants the
commercial banking system to rein in the boom in housing
finance. The RBI’s concern could be traced to the evidence
of a spike in lending for housing. Over the period April
1 to September 25, 2010, for example, housing credit
increased by Rs. 16,195 crore as compared to Rs. 7,891
crore over the corresponding period of the previous
financial year. What is more, during the 5-month April
to August period net credit provided by the housing
finance companies also rose by Rs. 7,519 crore as compared
with Rs. 3,581 crore during six months stretching from
April to September 2009. Among the techniques used by
banks to expand this market was, of course, the practice
of offering these loans at lower ''teaser'' interest rates
during the first few years, with the rates being subsequently
reset to much higher levels.
Realising that such practices tend to attract sub-prime
borrowers the RBI opted for four sets of measures. First,
it put a ceiling of 80 per cent on the Loan to Value
(LTV) ratio, which reduces leverage by requiring borrowers
to commit their own equity to the extent of at least
20 per cent of the value of the asset at the very beginning.
This reduces the risk burden on the lender. Second,
in a reversal of policies adopted earlier it has decided
to raise the average risk weight associated with larger
housing loans. A higher risk weight requires banks to
set aside a larger volume of regulatory capital for
a given loan size. When the risk weight on a particular
credit type is 100 per cent and the capital adequacy
requirement is 12 per cent, capital equivalent to 12
per cent of the loan has to be invested in specified
''regulatory'' assets. Since regulatory capital is supposed
to be in forms that are safe and relatively liquid,
the return on such assets is lower and reduces average
bank revenues. So increasing risk weights on any kind
of lending is expected to discourage that kind of lending.
Third, the RBI sent out a strong cautionary signal with
regard to the practice of offering teaser rates. In
its view: ''This practice raises concern as some borrowers
may find it difficult to service the loans once the
normal interest rate, which is higher than the rate
applicable in the initial years, becomes effective.
It has been observed that many banks at the time of
initial loan appraisal do not take into account the
repaying capacity of the borrower at normal lending
rates.'' Finally, having recognised that loans offered
with teaser interest rates have higher risk associated
with them, the RBI decided to increase the provisioning
required for these assets categorised as standard assets
from 0.40 per cent to 2 per cent, so as to take care
of that subset of loans that turns non-performing. The
message from the central bank is clear. India may have
avoided a crisis of the sub-prime type, but it remains
prone to such crises. Regulation and control are, therefore,
a must.
If Mr. Bhatt is peeved by these measures it could be
due to two reasons. First, he possibly would prefer
to lend more to housing when seeking to meet his priority
sector targets, since that would allow meeting a social
responsibility while ensuring a decent return. Second,
it is an area of lending outside the productive sectors
that assures a good return, which he feels that the
SBI should exploit. As he put it: ''Everybody knows,
I got a surplus of Rs. 1 lakh crore then. If I have
to park it at the RBI, I get only 3.5 per cent. What
I did was reduce the rate of interest to 8 per cent
and removed the cap on loans, so (borrowers?) could
even take Rs 1 crore. What wrong did we do?'' Perceptions
like this amount to saying that the State Bank of India
whch has always been a publicly owned bank and presented
as a trend setter for social banking should be allowed
to behave like any private bank with a thirst for speculative
profit. Thankfully, the RBI does not think so. What
is unclear is why Bhatt has decided to go public on
this at this stage in his tenure.
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